Financial speculators on congressional hot seat

Lawmakers to query role of investment money in commodity spikes

By

LauraMandaro

NEW YORK (MarketWatch) -- Pension funds and other institutional investors are driving commodity prices to the moon by allocating massive amounts of money to energy and agricultural investments and sidestepping regulatory limits on big speculative bets, according to research expected to be presented to Congress on Tuesday.

The research is the result of an investigation by Mark Lapolla, founding partner of investment-strategy firm Sixth Man Research; and by Mike Masters, portfolio manager of Atlanta hedge fund Masters Capital Management, who will be questioned by a Senate panel.

Lapolla said that he and Masters collaborated on research showing that the decision by pension funds to put a certain amount of money into commodities -- often carried out by what's known as passive-index trades -- has correlated with the spike in commodities prices, and also has circumvented regulatory limits on large speculative bets.

Indexed trading refers to investments linked to a benchmark commodities index such as the Dow Jones-AIG Commodity Index.

"The result [passive indexing] is having on the market is enormous because of its size, because its unidirectional and because it's indiscriminate on price," Lapolla said Monday. "The argument that they're having no effect is ridiculous."

'The argument that [passive-index trades] are having no effect is ridiculous.'
Mark Lapolla, Sixth Man Research

Equally ridiculous, according to Lapolla, is the idea that lawmakers or regulators can figure out exactly how much of an impact these index traders are having on prices.

But that's exactly what the Senate Committee on Homeland Security and Governmental Affairs will try to do when it questions Masters, along with the chief economist of the Commodities Futures Trading Commission and the president of the National Farmers Union. The panel is asking whether institutional investors and hedge funds are contributing to food- and energy-price inflation.

A fund that wants to buy a huge position in a commodity can enter into a so-called swaps contract with an investment bank, which can then buy futures. These swap arrangements skirt the limits that the fund, as a speculative or noncommercial trader, would typically face on buying futures. The investment bank can use an exemption from such limits because it's hedging these swaps.

The swaps loophole has allowed funds to allocate billions of dollars to a particular commodity, regardless of weekly or monthly fluctuations in price, according to Lapolla.

Tuesday's testimony could lend support to congressional efforts to curb such speculation.

The hearing in Washington follows a 30% gain in crude prices this year and surging grains prices, which have contributed to a more than 50% gain in global food prices in the past 12 months.

Responding to domestic disgruntlement over rising grocery and gasoline prices, as well as anger from some key U.S. allies over the country's role in global food inflation, some lawmakers have proposed increasing the margin requirements for hedge funds and other financial speculators. Such a requirement, which is favored by commercial traders of commodities, would increase the amount of cash funds need to ante up to trade in the futures markets.

Lehman Brothers just completed a study and found that the level of investment demand in commodities has soared to $215 billion from $70 billion a mere two years ago.

But there's far from a consensus on whether financial speculators are driving the rally or just exacerbating a boom triggered by tight supply and demand fundamentals.

The Commodities Futures Trading Commission, the chief U.S. regulator of futures trading, said at a public hearing in April that its analysis of indexed trading and agricultural-commodities prices showed no correlation between increased index trading and price spikes. See related story.

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